Lesson Overview

Properly pricing a trade to make enough money to cover the probability risk is one of the most overlooked aspects of selling options for monthly income. In this video, I'll show you exactly why most trades are frustrated and losing money long-term even though they are trading with a very high probability of success. Skip this video and you'll join their ranks.

More Discussion

Show Video Transcript +

In this video, I want to talk about correctly pricing your options strategies. You'll often hear the cry of failed traders who say things like, "I did everything right, and I still lost." "I won 80% of the time, but the biggest losers overshadowed all the small winners." "You can't win trading options."

High probability trading just doesn't work." I can almost assure you that their failure in most cases comes down to one major part that they're missing, and that is correctly pricing trades.

In today's video I want to walk through the correct way to price your trades, specifically credit spreads, iron condors, and debit spreads, based on the trades probability of losing and the overall risk.

By the end of this video, you'll see exactly why two different traders who make the same high probability trade entry could have dramatically different levels of success. It all comes down to, again, option pricing and correctly pricing these trades.

First, let's use our classic coin flip case study that I go through a lot with some of my premium members and coaching students, and I think it proves the point here that we're trying to make.

Here's the game here that we're going to play. We're going to flip a coin, obviously heads and tales. The odds of each side is 50-50, so the chance of flipping heads, 50% chance of flipping tails, 50%, but the minimum number of flips in this game is going to be 1,000.

We're not going to flip it one time, we're going to flip this coin 1,000 times, and that's going to be the end of the game. If it lands on heads, you win \$1. If it lands on tails, you lose \$1.

Here's how it would play out. We start the trade; you end up either flipping heads or tails and then from there heads or tails, heads or tails, heads or tails. At the end of 1,000 flips, there's probably a good chance that you have an equal number of heads and an equal number of tails.

It might not necessarily work out the first two flips that the trade makes, or the game makes, but at the end of 1,000 flips, you're going to have an even distribution of heads and tails.

How much money, at the end of the game, would you expect to make? Probably around \$0, not making any money, depending on the last flip. You might make \$1 or lose \$1 depending on the last coin flip as you hit \$1,000.

Now let's change up the game just a little, and keep in mind that you still want to make money with this game, because you still want to make money trading options. Here's the new game there we're going to play.

You're still going to flip a coin, it's still going to have the same odds, and still the same minimum 1,000 flips before we end the game. In this example, you're going to win \$0.70 every time that it lands on heads, and when it lands on tails, you're going to lose \$1.30.

All we did is just change up the pricing of the trade, or the pricing of the game, to where if it lands on heads you win \$70, if it lands on tails, you lose \$1.30. Do you still want to play this game? Who in their right mind would? Options traders do this all the time and don't even know it's happening.

The results of the new game would be 1,000 flips times the odds of winning, 50%, times the \$0.30 edge that is lost in the game just purely out of pricing, means that at the end of 1,000 flips you're going to have a \$300 expected loss at the end of the game.

Again, how long could you keep playing this game before you went flat broke? Probably not long, right? But again, so many traders are playing this game and don't even know it.

LEt's use a very specific options trading example to prove the point, and kind of start bringing this thing all together. At the time of this video, Twitter's stock is trading at about \$16.70.

Selling the 13.12 put credit spread, which is selling a put credit spread below where the stock is trading at \$16.70, gives you a credit of \$16, and the risk in the trade, since it's only a \$1-wide strike, is \$84.

So you could make \$16, or you could lose \$84. Based on option probability, we know that the 13 strike has a 21% chance of being in the money at expiration in 46 days. That's a known number. We can find that number in the options pricing table.

Think about this: There's a 79% chance of wining \$16, and a 21% chance of losing \$84. If we were to make this type of trade over and over over and over again in Twitter's stock, or anything else that has very similar pricing, we'd have an expected loss of \$5 on each and every trade that we make.

Every single time that we make a trade, we're expecting to lose \$5. So long-term, even with a high win rate we're still winning nearly 80% of the time. You can't expect to make money just purely based on the fact that there's really bad pricing.

This is where you start to see now the difference between a trader who can win often, and you'll hear traders often cry out and say, "I won 80% of the time," or, "I won 70% of the time, but I just didn't make any money."

You can still win with a high win rate, but your expected probability and the pricing of the trade can determine if you make money at the end of the day or not.

Now let's look at something different. Let's look at an iShares Brazilian ETF, which is EWZ; this is currently trading around \$26.10. Very similar, low-priced security that you can trade highly liquid, just like Twitter.

Selling the 29.5/30.6 call credit spread, so selling a spread above the market, you take in a credit of \$21, and your risk is \$79. In this case, we also know, because it's a known number that we can find, the 29.5 strike has a 21% chance of being in the money at expiration in 46 days.

If we made the EWZ trade the details would be as follows: A 79% chance of winning \$21, and a 21% chance of losing \$79. At the end of the day, if we made this trade over and over and over again, or trade very similar to it, our expected win or loss would be zero.

This is where most people would come in and say, "Aha, it's a zero-sum game." But now that you've built a trade that puts you in a position to exit early for profit and shift the odds in your favor, you can now win out with a trade like EWZ, as opposed to Twitter.

With a trade like EWZ, as long as you price it correctly as we showed you here, where you're taking in enough money to counter the actual risk of winning or losing in the trade, then having done nothing at all, so being a completely total lazy trader, not exiting the trade early, not managing your position, not adjusting it for a win or a loss, you end up with zero at the end of the day.

You can't hurt yourself, or you can't win or lose if you place a trade correctly. Now that you've placed a trade correctly, what if you closed just one of those trades early for a profit? What if you took one of those trades and cut the loss by making an adjustment to that trade?

Now you are taking that trade, and you're starting to increase, or shift, the odds in your favor long-term, which is exactly what we want to do. Here's how we can do that, obviously and we've talked about this here on track number two.

We can close trades early, we can bank profits, we can adjust trades to cut loss, and we'll naturally win on the fact that IV overstates the expected move. Which means that a trade that has a 21% chance of being in the money might only end up seeing 19% of the time being a loser.

IV, implied volatility, always overstates how far the stock might move at the end of the day, so we're going to win out a little bit more. By pricing our trade efficiently in the entry, gives us a lot more opportunity to do things with the trade that create profitable scenarios at the end of the day.

Yes, it's going to be hard to go through these trades and do the math that's required, but what's the alternative? You just make poor decisions; you just make bad trades? Do you just make trades like Twitter all day where you're not making enough money, and every single trade that you get into, you know you have lost a \$5 edge no matter what happens?

Yes, it's going to take a little work, but I promise you it gets easier over time. The more you focus on your targeted probability level, the easier it'll be to see good pricing.

This is why we always harp on the fact that you've got to choose a probability level that you're going to focus on. Focus on 70% winners, or 80% winners, and price every trade off of that so it's very easy for you to see, over time, how much each trade is going to be taking in, and if that's a good price.

Because you're looking at the same type of pricing every single time that you enter a trade. Yes, naturally higher implied volatility stocks and ETFs will have much better pricing across the board because higher implied volatility means higher option pricing, which means that you're going to be compensated a lot more for the same probability of success.

Of course, it's always good to double check. It's always a smart idea just in case option pricing isn't that high. Here's the formula that you need to follow. It's this, and again we'll get into it here in a little bit with more specifics, but it's this formula.

The credit that you receive has to be equal to the width of the strikes in a spread times the probability of that short strike being in the money. Again, the credit that you receive has to be equal to the width of the strikes times the probability of that strike being in the money.

To use our formula from the example above, if we had a \$1-wide strike, and there is a 21% chance of our short strike being in the money, we need to take in a credit of at least \$21 on that type of a trade for this trade to be fair, equal, and balanced, and for us to get good pricing.

If we had a \$1-wide spread and there was a 15% chance of the particular strike price, that the short strike being in the money, then we need to take in \$15 on a \$1-wide strike for the risk and the payoff to be equal and fair.

If we were trading a \$1-wide spread and there was a 30% chance of the short strike being in the money, then we need to take in a credit of at least \$30. You're starting to see this concept roll out.

Now, what happens if there's a \$5-wide strike, so now instead of a \$1-wide strike we're looking at a \$5-wide strike? Still the same 30% chance of being in the money. Now we take that 30% of the \$5-wide strike, and now we need a credit of \$1.50 for us to have a fair and neutral and kind of good pricing on this type of a trade.

Let's jump over real quick and look at some examples here because I want to prove the point in what we're trying to do here. This is a look here at CMG. CMG has a fairly high implied volatility right now, so option pricing should be pretty good here on CMG.

In this case, if we look at doing a trade that has an 80% chance of winning, we want to get some pretty good and fair pricing on an 80% probability trade.

If we look at the short strike of the 5.20 calls, they have about a 20% chance of being in the money at expiration, so there's an 80% chance that it's out of the money, 80% chance of being a winner, 20% chance of being a loser, or the strike being in the money. Again, I'm just rounding up here for even numbers and simple math.

If we do a credit spread, where we sell the 5.20 and buy the 5.25, this is a \$5-wide spread. If we use our formula, the \$5-wide spread, times the probability of being in the money, which is 20%, means that we need to be taking in a credit of at least \$1 on this trade to have a fair and good pricing balance on this trade.

You can see the credit that we're taking in on this trade right now is 1.05, so we're taking in a little bit more money than is required to enter this trade. Meaning that this trade, even if we did nothing at all, every single time that we enter a trade like this, we'd win out a little bit of money.

Before closing trades early, before managing positions and adjusting losses, we'd win out money because this trade is paying more than it actually should base on risk. This is a good entry because it fits our parameters here.

If we look at a different strike price, so let's say we look at doing the 4.95 calls, those have about a 30, 30% chance of being in the money, so a 70% chance of being a winner on that trade, 30% of being a winner on that trade, we would expect to take in a premium of about 1.50 on that trade to make it fair and neutral and balanced.

A \$5-wide spread, which is exactly what we have, times the risk of being in the money, which is about 30%, again I'm rounding down just for simple math, means that we want to take in a credit of at least \$1.50 on this trade for us to have a good pricing on this trade, and for us to make money long term.

You can see the credit that we're taking in, or we could take in, is about \$1.65. For a trade that wins 70% of the time, we're taking in \$1.65 in credit. Now let's look at something a little bit different that might not have as great of pricing.

Let's look at, actually let's look at LinkedIn, another high-priced security, and let's look at the same 20% probability of being on the money level like we did with CMG on the initial trade. If we look at LinkedIn, the 1.35 call options have about a 20% chance of being in the money at expiration, so about an 80% chance of winning.

Again, it's a \$5-wide spread, but notice with the LinkedIn trade, the \$5-wide spread, where we need to take in \$1 of credit, is paying out \$93. It's not paying enough money to compensate us for sometimes that we're going to lose on this trade.

Meaning that, if we make this trade, we're not collecting enough money to break the zero-sum game, and to pay out on the winners what we're going to lose when we do end up losing the 20% of the time.

If we look at something a little bit closer, just like we did with CMG, so let's look at these 1.29 calls that have a 32% chance of being in the money, so roughly a 70% chance of being a winner trade on this one, and if you look here, if we sell this spread, you can see that those are paying out just a little bit less than what they should be. They should be paying out about \$1.60, \$1.65 based on a 32% chance of being in the money.

Again, all we're doing is taking our \$5-wide strike, we're timesing that by the probability of being a loser on this trade, or the probability that the short strike is in the money, and those trades really need to be paying about \$1.60 per spread for us to want to make this trade.

Very, very close, but not exactly the type of pricing that we want. Again, this is why a lot of traders loose, is because they don't take the time to do these calculations, and to figure out which trade is paying out some really good money.

Let's look at one more example here just to prove the point. Let's look at Netflix. Netflix is another high-priced security so that we can use this one with \$5-wide spreads. The 20% probability of being in the money strike is the 1.20 call.

If we sold the 1.20 calls and bought the 1.25s, that's a \$5-wide spread. Notice how again, just like with LinkedIn, it's not paying enough money to make the trade.

The Chipotle trade that has the same probability of success as the LinkedIn trade and the Netflix trade pays out \$10 more every time that you win, with the same probability of success.

Yes, we had to go dig for it, yes it took a little bit more time, but the reality is that two traders who make the same high-probability trade in either Netflix or Chipotle or LinkedIn, only one of those traders, who's making that trade in Chipotle, is going to win more often, and win more money when they do, because of options pricing.

As we look at credit spread pricing guidelines here, and hopefully that was a good example as we run through some different pricing scenarios on our platform here, but when we look at credit spread pricing again, what we want to see is, we want to see that the net credit received is equal to the width of the strikes, whatever that ends up being, times the probability of the short strike being in the money.

At least that amount. You can get very, very close to it, but you want to have at least pricing that's within that range. For iron condors, it's no different. What we're looking for is, again, a net credit that is equal to the width of the strikes times the probability of being in the money, on both sides.

That's the one little caveat this time with this one, is that if you have an iron condor that has a 30% chance of being in the money on both sides, so maybe a 15% chance of being in the money on one side, 15% chance of being in the money on the other side, you need to still take in a credit that's equal to the width of the strikes.

Let's price this out with an example here, and this time we're going to look at Amazon so that we get a lot of different examples thrown your way.

You can see Amazon right now is trading at about \$5.92, but again, high-priced stock, so it kind of works with all the ones that we've been looking at. With an iron condor, we're going to build each side at the 15% probability of being in the money.

In this case, with Amazon, we'd be selling the 500/495 put spread down below the market, again that's at the 15% probability for our short strike. Then we go all the way up above the market to about the 6.70 short strike on the top side, sell the 6.70, and buy the 6.75.

Now we've created a nice, balanced iron condor in Amazon. It's \$5 wide on both sides, so that's the strike price width that we're looking at. Again, you don't have to add these up because you can't lose on both sides at the same time. You can only lose on one side or another.

The \$5-wide strike, times the probability of losing on both sides, which is 30% overall, remember, 15% probability of losing on each side, so we add those two together, that's how we get our 30% probability of losing on both sides, meaning that we need to take in a credit of about \$1.50 on this Amazon trade, which is exactly what this iron condor is pricing out right now.

In this case, the Amazon iron condor ends up paying exactly what the risk in the trade is, and that's because implied volatility is very high on Amazon. Hopefully, that was a good little example for iron condors.

If the trade were paying out say \$1.35, we wouldn't be getting enough premium to compensate us for the risk in the trade, so in that case, we would skip the trade, or not make it, or try to look for something different.

If we're doing a debit spread, we want to look for a net debit that's equal to the width of the strikes times the probability of being in the money, which is very similar to everything else, except we're looking for a net debit in this case.

What's different about debit spreads is that debit spreads are going to be directional in nature, which means that we usually make these trades with about a 50% chance of winning and about a 50% chance of losing.

We don't often use these as the core basis of how we generate income with options. They're mainly used for hedging, but the same principles apply, is that if you have a 50% chance of winning, and a 50% chance of losing, then our risk and reward should mirror that 50-50 kind of strategy, just like that coin flip that we talked about.

You want to make sure that you're taking in enough money in that type of a trade so that, if you don't end up winning on that trade, or if you make those trades over and over again, they don't hurt your portfolio because of really bad pricing.

If we go back here and use Amazon as a good little example here, you can see that Amazon stock is trading at 592.63 at the time we're doing this video.

If we want to use Amazon as a way to go long or short, or whatever the case is, let's look at just buying a debit call spread on Amazon, which is buying that at 590s, selling the 595s.

You can see that that price for the debit call spread right now is trading at 2.60, but the actual stock itself is trading at 592.74, so our break-even point on this thing is a little bit lower than where the stock is trading, but notice that our risk to reward is not the same.

It's a little bit off. We are not exactly making about 250 for every 250 we have at risk. This trade has about a 50% chance of being a winner or a loser.

Remember, this is a \$500 stock that's off in pricing and break-even points by \$0.14 or so this is about a 50-50 shot trade, but when we make this trade, our profit is not going to mirror that 50-50 that we're looking for.

We need this trade to be priced right around 250 for us to be confident in the pricing, and for just to be confident in taking this trade.

If we enter this trade at 250, notice that we can make 250 or lose 250, the break-even point would be about 592.50 again, which is very close to where the stock is trading given that it's an almost \$600 stock.

That would be a more fair type of a trade with the debit spread. We always try to get an even distribution of max profit and max loss with debit spreads because again, all they are are 50-50 bets. They're not meant to be our high-probability trades, so we want to make sure that we're pricing those good when we enter those.

Strangle and straddle pricing guidelines. This is where it's going to be a little bit different, obviously. You'll want to base risk off of the initial margin that's required, and again, this is something that's going to be different for your account, so we can't necessarily give you any hard guidelines.

We can talk about a little bit more, and we often do in some our weekly strategy calls with elite members, but it's hard for me to say, "You have to do this," because a lot of people have different margin levels, and improvement levels and brokers.

Even different brokers on the street will have different margin requirements for different trades, so I hesitate to give you ane exact guideline and formula for correctly pricing straddles and strangles because I don't want you to follow it if your broker's a little bit different.

Here's what I will tell you, is that it's gonna vary, and you have to remember that your break-even points are much wider than regular spreads.

For example, if we go back here to, let's say, Amazon, if we were to sell a naked put on Amazon at, say, the 655 strike, this naked put has a 20% chance of being hit, 80% chance of being out of the money at expiration.

I'm sorry, the 655 calls, not the puts. Has an 80% chance of being out of the money at expiration, but if we're taking a \$10 credit to sell those naked options, then really our break-even point is more around 665.

You have to remember that, with a straddle or a strangle, you're taking in a much larger premium because you don't have to buy options on either side. That's going to naturally widen out your break-even point, it's going to give you a little bit better overall win rate, and a wider range to make money at the end of the day.

Just keep that in mind. Again, there are no hard guidelines here. What I can tell you, obviously, is that with high implied volatility, that's when you want to do these straddles and strangles, because option pricing on both sides is going to be much more inflated, much richer.

You're going to get paid out a lot more for the same probability of success by doing these when implied volatility is high. Obviously, remember, you'll always win more than your initial probabilities show, and your break-even points are always a little bit wider when taking in credit, no matter if you're doing a straddle or a strangle or an iron condor or a credit spread.

That said, I hope this video serves as a great guideline for options pricing, and just the idea that we need to be more cognizant of how much money we're taking in, about the probability of actually losing on the trade.

Hopefully going through the coin flip example, the Twitter, EWZ, all the examples with CMG and Amazon and LinkedIn, really kind of drove home this point, because I think options pricing is really something that a lot of people really, really miss in this industry, and it's very, very important to your overall long-term success.

Thank you for checking out this video. Hopefully, it's been helpful. If you have any comments or feedback, I'd love to hear it. Ask them in the comment section right before this video.

If you loved it, though it was helpful in understanding a little bit more about options pricing and how to correctly price some of the strategies out there, I'd love if you could share this video out there online, help spread the word about what we're trying to do here at Option Alpha.